By Jason Pearce
The Two-Edged Sword
Archimedes made a great statement about the power of leverage when he said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” That’s a great quote…until it gets misapplied to the arena of speculation. Context is everything.
If you’re gonna talk about the advantage of using leverage in the financial markets, you would be irresponsible if you didn’t address a subject that’s intrinsically linked to it: risk. If you want to learn the correct way to use leverage, you need to consider more than just the potential gains that leverage can bring. You have to consider the potential losses.
The pros know that the winners take care of themselves. It’s the losers that have to be managed. The problem is, too much leverage can make the losing trades unmanageable even if you’re actively protecting yourself with stop orders. Leverage is the how the markets provide a trader with more than enough rope to hang himself.
Leverage Levels
Currently, a stock brokerage firm will allow customers to trade with leverage of 2-to-1. This is done by providing a margin loan to the trader. If a trader has $100,000 on deposit, the brokerage firm will loan him up to $100,000 and allow him to buy $200,000 worth of equities.
So a stock trader with margin could double his money on a stock that increases in value by 50%…and just as easily wipe out his stake if the price of the stock was cut in half.
Many people believe that trading commodities is far riskier than trading stocks. What?! Trading corn is riskier than trading Tesla?! This notion was likely brought about by the fact the available leverage for commodity trading is significantly higher than the leverage for stocks. So the belief is half right; commodity trading can be risker, but that’s because of the leverage available, not the instrument being traded.
That margin requirement to trade a futures contract is often around 5% of the value of the underlying contract. For instance, the E-mini S&P 500 is currently worth around $120,000. The initial margin requirement is $5,500, which is just 4.5% of the contract’s value. This would allow a futures trader to potentially leverage his account at a level of 20-to-1 where $100,000 on deposit can control as much as $2 million worth of futures contracts.
At a level of 20-to-1, a fully margined commodity account would make a fortune on a modest price increase. The other side of that coin is that the trader could also be completely wiped out on a 5% adverse move in price.
Forex trading reaches a whole different level of leverage…and insanity. Those sleazy online “bucket shops” that are always trying to sucker the public into currency trading offer traders leverage of 50-to-1…and 100-to-1…and sometimes even 200-to-1.
Just think about that in dollar terms. A $100,000 deposit in a forex account could control $5 million, $10 million, or even $20 million worth of currency.
At 100-to-1 leverage, it only takes a 1% change in price to double you money or lose it all. What could possibly go wrong?
Too Much of a Good Thing
Just as leverage can amplify investment gains, it also amplifies invest losses. This is why you never see professional traders and money managers taking full advantage of the leverage being offered.
It’s also why you’ve never heard of a professional trader racking up a month or even a year with a +1,000% return. To knock it out of the park like that, you’d have to take way too much risk.
As a matter of fact, one professional trader I know gets very concerned if he makes too much money over a certain period of time! His thinking is that he must be taking on too much risk or using too much leverage if the gains are accruing that quickly.
Professional traders make their trades based on probabilities. But they manage risk based on possibilities. If it’s possible for profits to snowball quickly, then it’s possible for losses to snowball quickly as well. To keep a losing streak from turning into an avalanche you’ve got to put limits on the amount of leverage used.
Bond Bubble Blowup
C.S. Lewis wrote, “Experience: that most brutal of teachers. But you learn, my God do you learn.” I’ve had the pleasure of having Professor Experience personally tutor me when I attended the University of Hard Knocks. My major was in What Not to Do When Trading.
Let me first say that mean reversion works…eventually. But if you’re going to make a bet on it and hold on, the trick is to make sure your position is small enough to survive the waiting period. The more leverage involved, the less staying power you have.
When I was a wise old trader in my twenties, I picked a fight with the bond market. Confidence and hubris was running high because I’d just come off of a couple of successful trade campaigns in the grain market and the Japanese yen. And now that the Treasury market was running away to record highs, I put them in the crosshairs and went short.
T-bonds were around 124-00 at the time, which is a value of $124,000 per contract. So initially, I went short one contract for every $20k in account equity and figured I could safely hold a contract with a $20k cushion and ride out the storm without needing a protective stop. Based on the contract value, I was leveraged at 6-to-1.
T-bonds just kept ripping higher and posted a record string of daily gains. Three weeks after I went short, I experienced an intraday drawdown of a little over $5,500 per contract. Perversely, my losses were ratcheting higher by the day while the probabilities of a reversal also increased.
But don’t confuse probable with possible.
The six-figure open loss caused me emotional turmoil. My $20k cushion shrank to $14,500 per contract. I was down, but not out. But I now had a bond contract value of $129,500 with a cushion of $14,500, raising the leverage to nearly 9-to-1.
Out of the Frying Pan
I called up another “professional” trader I knew in order to get his take on things. He asked me about my conviction on the trade. I told him I was still bearish and bonds just had to crash after a run-up like this! Somehow, an old floor trader saying popped up: “When in trouble, double”.
So I did. Seriously, I was already bleeding with a six-figure loss and then I proceeded to double my exposure by selling more contracts short at 128-24 ($128,750 value). By doing so, my equity cushion was suddenly $15,250 for every two contracts. Two contracts at that price are worth $257,500. That spiked the leverage on the position to nearly 17-to-1.
As you would expect, Treasuries only accelerated from there. The market posted daily gains and even some new all-time highs for several consecutive trading days.
When my trading accounts were just a stone’s throw away from a margin call, I finally tapped out. I lost about $9k for each initial short contract and another $4,250 for each ‘add-on’ short contract. My attempt at The Big Short wiped out two-thirds of my equity ($13,250 for every $20k), meaning a total loss of several hundred thousand dollars on the books.
Oh, and it gets even better…
As fate would have it, I covered all of those short positions just one day before the final record high was set! Bonds tanked the very next day and started the multi-month decline I was anticipating…but without me in it.
There are a lot of lessons to learn from this story: Don’t bet the farm on one big trade, don’t fight the trend, don’t trade without protective stops (or at least options to hedge), don’t depend on the opinions of others, etc.
But one lesson I want to bring highlight right now is that of using too much leverage.
Had I stuck with the original (flawed) plan, which was a fully leveraged position of 6-to-1, I would have still had to endure a wicked drawdown. But I would have never been forced to choose between liquidating or meeting a margin call.
By adding to a losing position and tripling my leverage to nearly 17-to-1, my protective buffer of equity was removed. I had no more wiggle room when the trade went further against me and I had to get out.
Bottom line: the amount of leveraged used was the only difference between being able to weather a major drawdown until I could eventually get out with a profit or being forced out early with major losses.
Miscalculating Risk
I stated earlier that too much leverage can make the losing trades unmanageable. A lot of times, this is due to the false sense of security that protective stops can bring. You may think you know what your risk on a trade is, but sometimes you can be wrong. Very wrong.
Suppose Sensible Sam is watching the soybean market and he thinks it’s about to take off. He has $100,000 in his account and wants to risk three percent of his equity on a soybean trade. That means he’ll have to put a protective stop order in the market to knock him out if the market moves against him by $3,000.
So Sensible Sam goes long three 5,000 bushel soybean futures contracts at $9.98 and places a protective sell stop at $9.78, which is twenty cents ($1,000 per contract) below his entry price. Although he’s risking just three percent of his equity, Sensible Sam is moderately leveraged at about 1.5-to-1 because he has actually purchased $149,700 worth of soybeans ($9.98-per-bushel x 15,000 bushels = $149,700) with his $100k account.
Along comes Gunslinger Gary. He’s also looking at the same soybean market and wants to get in on the action. He’s been burned before by risking way too much of his equity, but he still wants to capitalize on the expected move in beans.
Gunslinger Gary has a brilliant idea: buy a ton of contracts and set a really tight protective stop. Perhaps he is even going to follow Sensible Sam’s lead and risk just three percent of his $100,000 account…but that’s where the similarities stop.
Gunslinger Gary buys twenty 5,000 bushel soybean futures contracts at $9.98 and places a really tight protective sell stop at $9.95, which is just three cents ($150 per contract) below his entry price. Theoretically, he’s only risking three percent of his equity. However, trouble is brewing because Gunslinger Gary is leveraged at 10-to-1. He has actually purchased $998,000 worth of soybeans ($9.98-per-bushel x 100,000 bushels = $998,000) with his $100k account.
Maybe Gunslinger Gary’s protective stop placement actually makes sense because he’s using intra-day charts to time a quick exit. That’s not what I’m concerned about. But we can’t escape the fact that he’s substantially more leverage than Sensible Sam.
Let’s forget about the best-case scenario where beans go ripping higher right after these guys get in. Consider what happens if the market drops instead.
What if Gunslinger Gary’s protective stop is elected and he gets three-cent slippage on the fill? He’ll lose $6k instead of $3k. That’s double what he thought the risk was.
Or what if he manages to stay in the trade but an adverse crop report hammers the beans down 20 cents in the afterhours market where slippage is even greater or beans gap down in the morning (if he’s using pit-session stops only)?
In this scenario, Sam would also get knocked out of his three soybean contracts and suffer the $3k loss. But good ol’ Gunslinger Gary would get murdered. The 20-cent loss on his twenty soybean contracts would cost him a whopping $20,000. That one trade would wipe out one-fifth of his account.
Although I used a hypothetical scenario to show the damage that leverage can inflict on a losing trade, don’t think for one moment that it’s not a plausible scenario.
Ask anyone who’s ever traded grains in the summer or had a position on when a crop report came out and you’ll hear tales about the market instantly moving limit. Sometimes, the market will even move lock limit. If you’re on the wrong side of that move, it means you can’t even get out at the market price!
Currently, the CME set the limit for soybeans at 70 cents ($3,500 per contract). That limit amount can get raised by 50% in a heartbeat.
The takeaway here is that leverage is just as important –maybe even more so- than protective stop placements when calculating your true market risk. Yes, you should have protective stops. But you should also have leverage limits. Leverage is like medicine: a little bit can help you…but too much will kill you!
Highly-Leveraged Is Relative
Most traders have heard the famous story about how George Soros “broke the Bank of England” by betting against the British pound back in 1992.
Soros’ right-hand man, Stanley Druckenmiller, was the one that pitched Soros the idea of shorting Sterling. Druckenmiller said that Soros taught him to “go for the jugular” when you have a very strong conviction on a trade and to ride a profit with huge leverage.
Obviously, the plan worked. They made over $1.5 billion on that trade.
Now, what many people don’t know is the size of that leverage on the trade. Druckenmiller suggested to Soros that that they put 100% of the fund in the trade. Soros disagreed. He said they should have 200% in the trade.
Having 200% means leverage of 2-to-1. That’s not 10-to-1 or 20-to-1 like a lot of novice commodity traders use and it’s certainly not 50-to-1 or 100-to-1 like the snake oil FX brokers tell the public they can use, either.
Druckenmiller said in one interview that the leverage at Quantum (Soros’s hedge fund) rarely exceeds 3-to-1 or 4-to-1. So if one of the best traders in history doesn’t go beyond 4-to-1 leverage, why the heck would a lesser trader think that going 10-to-1 or more is a good idea?
Do keep in mind that just because they leveraged 2-to-1 does not mean that they were risking the entire amount. Soros is known for taking a quick loss without regret if the market proves him wrong.
Market Wizard Wisdom
Larry Hite is one of the Market Wizards interviewed Jack Schwager’s famous book. On the subject of leverage, he said that, “…if you leverage more than 3-to-1 that you are a loser. Because we found that if you did 3 to 1 you would have, even with perfect knowledge, you could go down a third.”
So here we’ve got yet another successful trader with several decades of performance to back his reputation, and he’s telling traders that the maximum leverage that they should consider is 3-to-1.
There are only two reasons I can think of that a person would use higher leverage than what the pros use: ignorance or greed. And once you are made aware of the risk of using high leverage, you can no longer claim ignorance for your excuse.
Protect Yourself
Brokerage firms want you to use the available leverage. The more you trade, the more commissions they make. Don’t think for a minute that they’re going to step in and tell you that you’re taking too much risk.
Sure, the brokerage firms will issue margin calls. But that’s not about protecting you; it’s about protecting them. Brokerage firms don’t mind if you are burning through your trading capital. “Churn and burn, baby.” It’s just when the flames get too close by putting them at risk of a potential deficit that they’ll step in and tell you to wire more money to your trading account or liquidate your positions.
Surely, the good ol’ US government is protecting you, right? Well, consider this: The SEC just approved the launch of a 4x leverage ETF.
I wrote in a prior post about how leveraged ETFs are constructed as an easy way to the poorhouse. You can be right on the underlying market and still lose money. That’s the effect that double and especially triple leverage ETFs can have.
But now the government is going to allow us to trade in quadruple leverage ETFs?! Maybe it would be more accurate to re-label these genius derivatives as WTFs…
The point is that nobody is going to be as careful about protecting your capital as you are. To be successful, a trader and investor must be proactive and accept personal responsibility. Part of this includes understanding and setting limits on leverage.
It Can Get Worse
Do you have a trading system that you’ve back-tested over decades of data? Have you tested it on out of sample data as well? Have you run a Monte Carlo simulation on it, too? That’s good. You’ve done your homework.
I’m sure you also remembered to factor in commissions and slippage in order to get a better feel for real world trading. You now know what sort of worst case drawdown would’ve occurred, which can help you determine your comfort level for the amount of leverage you’ll use to trade it. Time to get trading.
Not so fast!
The well-respected trader Peter Brandt said, “A trader’s worst drawdown is the one yet occur.”
Consider that fact that the worst drawdown in your back-testing record or even your real-time track record got that title by being even worse than all the prior drawdowns that preceded it. That means it’s possible that another drawdown can come along and steal that title at some point.
All records were made by breaking another record. That can be both a good thing and a bad thing. On the subject of drawdowns, it’s definitely a bad thing.
Storm Prep
One simple way that a trader can build a protective buffer is to prepare for a drawdown that’s double the size of the biggest one to date. This means adjusting your risk-per-trade to a level that will allow you to endure such a losing streak.
Furthermore, you may want to calculate what your entire portfolio risk is. This means looking at the effect of a worst-case-scenario where every position in every sector of your account gets stopped out with slippage. This drawdown is your Portfolio Meltdown Level. It rarely, if ever, will happen. But you still need to be prepared for the possibility of it occurring.
Does that Portfolio Meltdown Level make you sick? Well, it’s a good thing that you’re calculating it then! You just discovered that you’ve been taking too much risk…and you’re lucky enough to have not found out from experience. Dial the Portfolio Meltdown Level back down to your comfort level. Figure out what you want to set for your maximum risk level for each trade, for each sector, and for your entire portfolio.
Preparing a worst-case scenario defense plan also means reigning in the amount of leverage used. Just because you have protective stops in for your positions, doesn’t mean your maximum expected risk level is guaranteed. If some of the rock stars of the trading world think the maximum leverage they should use is 3-to-1 or 4-to-1, then perhaps you should consider adopting these levels as your maximum leverage limits as well.
We don’t know when the storm will hit, but we do know that it’s inevitable that it will happen someday. Your job as a trader is to make sure that you are taking the necessary precautions to survive it. Remember that your probabilities of trading survival are inversely correlated to the levels of leverage that you use.
More Articles by Jason Pearce:
US Dollar: The New Bear Market?
Equities: US Against the World
Profiting From Failure: The Wash & Rinse Trade, Part II
Profiting From Failure: The Wash & Rinse Trade, Part I
How to Trade with Moving Averages, Part II
How to Trade with Moving Averages, Part I
Market Returns Do Not Equal Investment Returns with Leveraged ETFs
Is The Canadian Housing Market Bad for Canadian Banks?
2017: The Death Year for Stocks
Potential Bond Market Reversal Ahead
